Financial Engines Management Discusses Q2 2013 Results - Earnings Call Transcript

Aug. 1.13 | About: Financial Engines, (FNGN)

Financial Engines (NASDAQ:FNGN)

Q2 2013 Earnings Call

August 01, 2013 5:00 pm ET


Raymond Jay Sims - Chief Financial Officer and Executive Vice President

Jeffrey Nacey Maggioncalda - Chief Executive Officer and Director


Robert P. Napoli - William Blair & Company L.L.C., Research Division

Hugh M. Miller - Sidoti & Company, LLC

Michael J. Grondahl - Piper Jaffray Companies, Research Division

Avishai Kantor - Cowen and Company, LLC, Research Division


Good day. And welcome to the Financial Engines Second Quarter 2013 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mr. Ray Sims, Chief Financial Officer. Mr. Sims, please go ahead, sir.

Raymond Jay Sims

Good afternoon, and thank you all for being on today's call. I'll begin with our industry-leading, award-winning forward-looking statement disclaimer. I need to remind everyone that part of today's discussion will include forward-looking statements, such as statements regarding our operating metrics; anticipated costs and expenses; growth and growth opportunities; strategy; trends impacting our business; our competitive position; impact of new laws and regulations; enrollment rates; implementation and potential impact of enrollment enhancements and strategies; anticipated benefits, success and impact of our services, including Income+; anticipated adoption of our products and services; anticipated benefits and impact of customer experience enhancements; long-term objectives; and financial outlook for 2013.

These statements are based on what we expect as of this conference call, as well as current market and industry conditions, financial and otherwise, and we undertake no obligation to update these statements to reflect events, circumstances or changes that might arise after this call. These forward-looking statements are not guarantees of future performance or plans, and therefore, investors should not place undue reliance on them. We refer all of you to our SEC filings for more detailed discussions of the risks that could impact our future operating results and financial conditions, which could cause actual results to differ materially from those discussed in these forward-looking statements.

I also want to inform our listeners that we will make some reference to non-GAAP financial measures during today's call. You will find supplemental data in our press release, which reconciles our non-GAAP measures to our GAAP results. Now I would like to turn the call over to Jeff Maggioncalda, our Chief Executive Officer.

Jeffrey Nacey Maggioncalda

Thanks, Ray. Good afternoon, everyone. Thank you for joining us today. I'm pleased to report that Financial Engines had a good second quarter. Let's take a look at our numbers for the quarter.

Revenue increased 30%, $57.8 million in Q2 compared to $44.3 million a year ago. Non-GAAP adjusted EBITDA increased 45%, $17.8 million in Q2 compared to $12.3 million a year ago. And non-GAAP adjusted earnings per share increased 45% to $0.16 in Q2 compared to $0.11 a year ago.

In addition to our financial performance, we report quarterly on some important operating metrics, including assets under management, assets under contract, total members and enrollment rates. Please refer to our SEC filings for definitions of these operating metrics.

We had a solid quarter against each of these metrics. As of June 30, assets under management reached $74.3 billion, a 37% increase from $54.2 billion a year ago. Assets under contract increased by 24% to $667 billion from $536 billion a year ago.

Total members enrolled in Professional Management grew to more than 713,000 members. Enrollment rates among employer plans where services have been available 26 months or more averaged 12.9% at the end of the second quarter.

There are a number of fundamental forces driving our growth opportunity. As we've discussed previously, demographic trends continue to drive our business.

When Financial Engines was founded over 17 years ago, we recognized the generational opportunity represented by the investment needs of the 78 million Baby Boomers, who today account for over 26% of the U.S. population.

We recently celebrated our Founder's Day. And in that spirit, we remember that Bill Sharpe recognized decades ago that the responsibility of investment decision-making would shift from the employer to the employee. We knew that it was just a matter of time before Baby Boomers would be forced into one of the most complex and uncertain retirements in history. The time has come. Baby Boomers are now retiring, and we believe that what we have accomplished over the past 17 years has put us in an extremely attractive position to help them.

In addition to demographics, we believe another factor driving our growth is the increasing reliance on defined contribution plans. As Baby Boomers transition into retirement, they'll continue to rely more and more on defined contribution plans and less and less on defined benefit pension plans as employers continue to freeze and terminate these benefit plans.

According to projections by the Urban Institute, the median predicted pension wealth for participants in defined benefit plans is expected to drop by nearly 50% between the pre-Boomer cohort and the late Boomers. This wealth has shifted into defined contribution systems.

A recent Towers Watson analysis revealed that in 2007, over half of the largest 100 U.S. sponsors had fully funded pension plans. In 2012, only 5 companies in this group were fully funded.

With stronger markets in 2013, pension plan funding status has improved, and this creates an opportunity for plan sponsors to lock in gains and examine ways to move liabilities off of their balance sheet completely.

Favorable legislation related to lump-sum payouts, alongside the recent risk-transfer strategy taken by large U.S. companies in 2012 and 2013, is bringing more attention to the topic of pension plan de-risking.

A joint Mercer and CFO Research survey of plan sponsors found finance executives show a growing interest in transferring the risk, either partially or completely, in their efforts to manage continuing obligations effectively.

Financial Engines' current plan sponsor customers represent about $600 billion in defined benefit assets. We believe that plan sponsors offering lump-sum distributions presents an opportunity for Financial Engines to manage additional assets, especially with the availability of IRA management and Income+.

Financial Engines also continues to benefit from significant legal and regulatory tailwinds. In April, a resolution introduced in the Senate expressed the sense of Congress that the current tax incentives for retirement savings provide important benefits to Americans and strengthens retirement security for all. Efforts to preserve existing incentives demonstrates that policymakers recognize the important role that retirement savings plans play in encouraging employees to save for retirement.

At the state level, late last year, the State of California enacted the California Secure Choice Retirement Savings Program that established automatic payroll contributions into IRAs for workers without access to employer-sponsored retirement savings plans. Other states are beginning to put forth similar proposals.

Under the new system, unless participants opt out, an automatic 3% will be deducted from the paycheck of eligible employees, and the contribution will be saved in an IRA-type account. While enrollment will not begin until 2015, this law illustrates that legislators recognize the imminent retirement tsunami and the lack of general preparedness among American workers.

Financial Engines continues to be part of the important discussions in Washington, D.C. In May, the Department of Labor issued an advance notice of proposed rulemaking, entitled Pension Benefit Statements, which would mandate a projected retirement income forecast to be included in annual benefit statements to participants. The DOL issued this advance notice of proposed rulemaking to solicit industry input on a wide range of questions before they issue the proposed rule. Financial Engines will submit a comment letter later this month.

It's important to note that Financial Engines has been providing millions of plan participants with income projections since 1998. In 2012 alone, Financial Engines provided over 3.5 million personalized retirement income forecasts in print to participants.

We believe it is important for the DOL to explicitly encourage the use of more robust, personalized methodologies than the simple Safe Harbor outlined in their proposal. This initiative related demonstrates the importance that the DOL places on the lifetime income disclosures and a plan participant's retirement security.

Another key trend we observe today is the increased help 401(k) plan sponsors are providing to plan participants. Automatic enrollment, encouraged under the Pension Protection Act of 2006, has been a meaningful step taken by plan sponsors to increase their plan's participation rates and help their participants save more for retirement.

And the 2013 Workplace Benefits Report published by Bank of America Merrill Lynch indicates that participants may be looking for more help from their employers. 51% of employees surveyed indicate that they would like their employers to provide one-on-one access to a financial advisor, and 59% reported they need help managing retirement savings. With many plan sponsors reviewing the retirement readiness and financial wellness of their employees, we believe that we are uniquely positioned to provide the personalized holistic help that participants may be seeking from their employer.

So our growth opportunities continue to benefit from demographic trends and increased reliance on 401(k) plans, legal and regulatory tailwinds and demand for investment advice in the workplace.

Now I'd like to discuss our strategy to take advantage of these growth opportunities and the progress that we're making.

Let's start with assets under contract, which is the value of assets in retirement plans where Professional Management has been made available.

Assets under contract rose to $667 billion by the end of Q2, up from $635 billion at the beginning of the quarter and up 24% over the last year.

The year-over-year growth in the second quarter was driven primarily by the positive performance of financial markets over the last year, new employers making our services available and the steady contributions that participants and employers make into their 401(k) accounts.

Competitors, including new investment advisory firms and established players alike, appear to have increased their focus on providing managed accounts for the 401(k) market. We recognize that we will need to continue to broaden the scope of the services we offer and improve the customer experience in order to further differentiate from target date funds and managed account competitors as we grow our AUC.

We believe that improving the customer experience will also drive engagement, enrollment and retention.

First, we continue to focus our efforts on converting assets under contract into assets under management by improving enrollment. In June, InvestmentNews ranked Financial Engines as the largest fee-only registered investment advisor in America among those providing advice to individual investors on a discretionary basis. Financial Engines has more than twice the assets under management of the next-largest RIA providing services in this slate.

In Q2, we added $4.7 billion of AUM from new enrollment, yielding $2.5 billion net of voluntary and involuntary cancellations. This growth in AUM was due to high campaign volume and increasing ongoing enrollment. We now have 16 plan sponsors who each have more than $1 billion in plan assets being professionally managed by Financial Engines.

In addition to enrollment campaigns, we're pleased with the ongoing progress from our integrated enrollment efforts and continue to focus on noncampaign enrollment methods. Our integrated enrollment capability, available through our largest provider partners, covers about 85% of our AUC. We are actively developing new content and testing the content with plan participants to drive higher levels of engagement and enrollment. We continue to increase the speed and quantity of messaging to participants, but we are encouraged by the progress and the effectiveness of this enrollment method.

Vanguard launched integrated enrollment capabilities in Q4 of 2012. In July of this year, Vanguard released early results from their online efforts and indicated that integrated enrollment increased engagement enrollment at meaningful rates. We believe a digital presence on the provider's site will help increase our enrollment rates by improving the customer experience and engaging more participants throughout the year.

We continue to make progress understanding what drives enrollment, designing more effective communication programs and deploying these programs more broadly across our install base. Enrollment for employers rolled out 26 months or more averaged 12.9% at the end of Q2.

An attractive characteristic of our business model is the built-in growth that comes from ongoing contributions from 401(k) participants. Every 2 weeks, a part of most participants' paychecks is deducted and deposited into their 401(k) account, which is usually partially matched by their employer. We estimate that in addition to the $2.5 billion of AUM from net new enrollees, our AUM increased by approximately $1.3 billion more in Q2 due to member and employer matching contributions, an increase of 30% over last year.

The How America Saves report, recently issued by Vanguard, discusses the growth of automatic saving features and found that 7 out of 10 plans with automatic enrollment have implemented automatic annual contribution escalations to encourage higher savings rates. The net inflows from contributions have steadily risen as our member and AUM base has grown and Americans continue to increase their savings rates

We continue to focus on retention of Professional Management members. Our increased retention efforts are currently focused on reducing voluntary cancellations. We believe that we can reduce cancellations over the coming years by increasing personalization, flexibility and the breadth of services we offer. A current area of focus for improving retention is with members in the first 90 days, where we see a larger portion of our voluntary cancellations occur. We are developing and testing programs, which allow for other types of personalization and flexibility, as well as improving communications about the services and the capabilities with members early in the relationship.

For the second quarter of 2013, our average quarterly overall cancellation rate was 3%, which is somewhat lower than our historical cancellation rate, and which we believe is attributable mostly to favorable financial markets.

Our other primary growth initiative is Income+, retirement income feature that provides retirees with a steady monthly paycheck from their 401(k) to a checking account that can last for life.

We continue to make progress deploying Income+ with our provider partners and plan sponsors. We are pleased to report that the U.S. Patent and Trademark Office has approved our patent application for Income+, titled: Creating and maintaining a payout-ready portfolio within an investment plan to generate a sustainable income stream. This patent protects our unique Income+ calculation methodology. The Income+ plus patent represents our 15th patent issued. Other patents of note include those that cover tax-aware asset allocation; outcomes-based investing, including our financial advisory systems; a user interface for the financial advisory system; our pricing module; load-aware optimization; and financial goal planning and advice palatability. As I've said in the past, we believe there's an opportunity to establish Income+ as a standard for retirement income in the workplace. As the demographic wave of Baby Boomers enters into retirement, we believe that employers will be motivated to help generate lifetime income. We believe we are establishing ourselves as a leading retirement income solution and enjoying multiple barriers to entry and first mover advantages to prevent competitors from encroaching on this landscape. One barrier to entry is legal protection, which we have just received in the form of the patent. Another barrier is the technological and methodological difficulty of replicating our Income+ methodology.

But perhaps the greatest barrier is the standards effects that happens when a large population of plan sponsors embraces an emerging standard. We are encouraged by the market momentum we have established with Income+. Providers who have committed to offering Income+, including those whose connections are not yet live, represent more than 95% of our AUC. In July, an additional provider partner's established a live Income+ connection, and provider partners with live Income+ connections now represent nearly 70% of our AUC. We believe the broad adoption of Income+ by plan providers and plan sponsors positions Financial Engines to become the standard for retirement income in 401(k) plans.

As of June 30, 2013, plan sponsors who made Income+ available to their participants represents $52 billion in assets under contract, an increase of 148% from the second quarter of 2012 and more than $528,000 participants.

Sponsor and participant response to broader advisory services continued to be positive and reinforces our unique ability to provide holistic advice that is independent and free from conflicts, and we will continue to invest in developing these efforts.

We strongly believe that retirement income help should include consideration of the broader retirement planning picture.

In particular, we are seeing considerable interest from plan sponsors who incorporate Social Security help into our Income+ service in order to maximize the retirement income of their employees as they approach retirement. Evaluating their options and developing a Social Security claiming strategy to decide when and how to claim Social Security benefits can be perhaps the most important financial decision a plan participant will ever make. With over 8,000 Social Security claiming combinations that a couple could make, Social Security is one more example of the myriad of complex retirement decisions that Baby Boomers are facing. We believe that the flexibility of our Income+ framework will allow us to incorporate help on Social Security by linking Social Security and claiming strategies with overall investment and drawdown strategies. This allows us to help participants make good use across all income sources, including 401(k)s and IRAs, Social Security and pensions, and to have an integrated and consistent experience with us.

Beyond the workplace, Financial Engines can now provide IRA management with the Income+ capability for members and their spouses on custodial platforms with Charles Schwab and TD Ameritrade. We intend to establish connections with additional leading IRA providers to extend our open-architecture platform. In the near term, IRA management will be offered only to Professional Management members at select sponsors in the Financial Engines direct channels. We are proceeding with further validation and testing of our broader retirement management offering, and we will continue to invest over the longer term to learn more about participant behaviors and to expand and deploy this platform. We believe that extending our offering to include the management of IRA as well as 401(k) accounts will better engage members and help drive enrollment. And broadening our services will also differentiate us from competitors and products like target date funds. We believe also that expanding our service offering will help mitigate the pricing pressure prevalent in the industry. And we expect our IRA capability can improve sponsor and member satisfaction, revenue per member and voluntary and involuntary cancellation rates over time. We expect that the larger benefit of IRA management and Income+ will be realized over the longer term as the demographic wave of Baby Boomers retiring continues over the next 2 decades.

We continue to expand the number of retirement plan sponsors that we serve. At the end of the second quarter, we had 530 plan sponsors where Professional Management was available, representing $667 billion in assets and about 7.1 million participants. At the end of the second quarter, we were managing portfolios worth $74.3 billion for more than 713,000 members, and half of those members had less than $47,000 in their accounts.

As of June 30, 2013, 142 of the Fortune 500 have hired Financial Engines to help their employees, and our advice is available to over 8.7 million participants. When I look at the fundamental trends driving our growth, the breadth and strength of our relationships and the quality, scalability and uniqueness of our services, I feel that Financial Engines is increasingly well positioned to take advantage of a significant market opportunity to deliver on our promise of providing everyone with the independent, personalized retirement help they deserve.

Now I'd like to turn it over to our CFO, Ray Sims, to discuss our financial results in more detail. Ray?

Raymond Jay Sims

Thanks, Jeff. As Jeff said, total revenue increased 30% to $57.8 million in the second quarter of 2013 from $44.3 million in the prior year period. The increase in revenue was driven primarily by growth in Professional Management revenue, which increased 38% to $48.5 million in the second quarter of 2013. Professional Management revenue growth was driven by higher AUM, which reached $74.3 billion at the end of the second quarter compared with $54.2 billion ending the prior year period. This increase in AUM was the result of market performance, as well as increased enrollment from marketing campaigns and other ongoing member acquisitions and contributions.

Platform and other revenue was up 2% to $9.3 million for the second quarter of 2013 compared with $9.1 million for the second quarter of 2012.

Cost of revenue, exclusive of amortization of internally used software, increased 30% to $22.5 million for the quarter compared to $17.3 million for the prior year period. As a percentage of revenue, cost of revenue remained constant at 39% in the second quarters of 2012 and 2013.

As most of you already know, employee-related costs are our largest expense and include items such as wages, cash incentive compensation, noncash stock-based compensation and benefits. The expense variances that I will be talking about within each of the functional areas were driven primarily by increases in employee-related wages, benefits and employer payroll taxes from growth in headcount and annual cash compensation increases. Noncash stock-based compensation expense increased in the second quarter of 2013 across many functional areas, due primarily to the commencement of a performance-based long-term incentive program.

Corporate depreciation expense, which is allocated based on headcount, also increased across each of the functional areas, due primarily to equipment purchases associated with our new headquarters facility during the past year.

Research and development expense increased to $7.6 million for the quarter, up 26% from $6.1 million in the prior year period, due primarily to increases in employee-related expenses such as wages, benefits, cash incentive compensation and noncash stock-based compensation. As a percentage of revenue, R&D decreased from 14% in the prior year period to 13% this quarter as employee-related expenses grew at a slower rate than revenue.

Sales and marketing expense increased to $10.9 million for the quarter, up 15% from $9.5 million in the prior year. This increase was driven primarily by increased employee-related wages, benefits and noncash stock-based compensation expense, as well as an increase in general marketing programs and activities. As a percentage of revenue, sales and marketing expenses decreased from 21% in the prior year period to 19% this quarter, as employee-related expenses grew at a slower rate than revenue.

General and administrative expense increased to $5.1 million for the quarter, up 35% from $3.8 million in the prior year quarter, due primarily to increases in employee-related expenses such as noncash stock-based compensation expense, wages, benefits and cash incentive compensation, as well as professional services and consulting expense.

As a percentage of revenue, general and administrative expense remained constant at 9% in the second quarters of 2012 and 2013.

Income from operations, as a percentage of revenue, increased to 17% for the second quarter of 2013 from 14% in the prior year period. Net income increased to $6.3 million in the second quarter of 2013 compared with net income of $3.8 million in the second quarter of 2012.

As many of you know, we look at non-GAAP adjusted EBITDA as a key measure of our financial performance. Our earnings release has a table that reconciles our GAAP net income to adjusted EBITDA. Adjusted EBITDA in the quarter increased to $17.8 million, up 45% from $12.3 million in the second quarter of last year. Adjusted EBITDA is one of the metrics we use to determine employee cash incentive compensation. We provide further information about the calculation of our non-GAAP adjusted EPS in today's earnings release.

Non-GAAP adjusted EBITDA was $0.16 in the second quarter of 2013 compared with $0.11 in the second quarter of 2012.

In terms of cash resources, as of June 30, 2013, we had total cash, cash equivalents and short-term investments of $216 million compared with $153 million as of June 30, 2012.

On July 30, 2013, Financial Engines' Board of Directors declared a cash dividend of $0.05 per share of the company's stock. The cash dividend will be paid on October 4, 2013 to stockholders of record as of the close of business on September 20, 2013.

Now on to our outlook for 2013. Based on financial markets remaining at July 29, 2013 levels, when the S&P 500 index closed at 16.85%, we estimate 2013 revenue to be in the range of $233 million to $238 million and 2013 non-GAAP adjusted EBITDA to be in the range of $75 million to $77 million. We estimate that from July 29, 2013 market levels, a sustained 1% change in the S&P index on July 29 through the end of 2013 would impact our 2013 revenue by approximately 0.32% and our 2013 non-GAAP adjusted EBITDA by approximately 0.57%, all else being equal.

While we have historically provided sensitivity based on the S&P 500 for simplicity, we encourage investors to utilize the breakdown of our aggregate portfolios provided in our earnings release to run more accurate sensitivities.

As happened in Q2, international equity, particularly emerging markets and bond market performance, deviated substantially from the S&P 500's performance, resulting in a net overall market decline. For more accurate sensitivities, the recommended indices are the S&P 500 for domestic equities, MSCI EAFE Index for international equities and the Barclays Capital U.S. Bond Index for bonds.

Our outlook for 2013 is consistent with the longer-term objectives we shared with you earlier, which assume fairly normal market conditions: revenue growth of 20% to 30% per year, operating margins of 15% to 20%, long-term EPS growth of 25% to 40% per year, assets under management growth of 25% to 30% per year and enrollment rates and plans rolled out for 26 months or more of 12% to 15%.

With that, operator, we would now like to open it up to questions.

Question-and-Answer Session


[Operator Instructions] The first question we have comes from Bob Napoli of William Blair.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

A question on – a little more clarity on your strategy around income and retirement. I was just trying to understand a little more on what you're doing there. It sounds like you -- besides the IRA and trying to roll in Social Security, and I wondered how far away you are from that, it sounds like you're also looking to take defined benefit pension plans into the overall Income+ product. Is that right? And how far away are you from integrating some of -- a number of these products?

Jeffrey Nacey Maggioncalda

Bob, so this is Jeff. Without giving specific ship dates or anything, I can tell you that the way that we typically deal with our R&D -- we do run parallel projects, but we have found that really concentrating on a few big R&D-intensive initiatives at a time gives us better results. And obviously, a few years ago -- actually, for many years, Income+ was the major focus. And then more recently, we announced the IRA piece, and that represented a major focus. And I can say that right now, pulling these income sources together into a holistic income plan that includes other sources of income, including Social Security, is a major concentrated effort. So as we think about where the next needs are of our customers and how to pull these pieces together, it is definitely a primary focus of ours. And we're in the stages of showing it to customers, getting feedback, so it's definitely coming along. And I would expect it to be well inside of a 3-year horizon or even a 2-year horizon. I mean, it's something that really is front and center on our radar screen right now.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

So who's trying to compete with you on this product? I know you got the patent -- you mentioned your patent up front, but who else is going after something like this?

Jeffrey Nacey Maggioncalda

Well, I think that there are different ways to think about competition. As we think about our space, we think of it, really, as competition to provide retirement income services to people within the workplace. And so clearly, annuity providers outside of the workplace are a major source of product sales to help people figure out how to turn a pool of assets into a lifetime income stream. In the workplace, we have seen, over the last 5-plus years, the primary competitors have been insurance companies. But there's been a lot of reluctance among plan sponsors to have to deal with counter-party risk and regulatory uncertainty, cost and things like that. So we really haven't seen very much in the way of direct competition, at least anyone getting traction. BlackRock announced recently that they are making a second run at providing retirement income services to the workplace, the first being sponsor match, which was an offering that they had, had in the market for many years before, I think, shelving it after getting, I think, less than a handful of plan sponsors. And so this is another sort of effort that they're taking on, and I expect that they'll be a competitive force in the marketplace. There are still insurance companies who are working on insurance-based retirement income services. That's been happening now for 5-plus years. And like I said, there's certain challenges with the annuities. There are also, I think, investment-oriented solutions providers like BlackRock that are trying to wrap something around target date funds, and that's been something that folks have been trying to do for 5-plus years. So we do see a bit of competition from various places. But I think the real trick is finding a solution that works for participants in delivering lifetime income and also works for the plan sponsor, given their risk-averse stance with respect to really doing anything that would be either uncertain or -- from a regulatory perspective or have potential conflicts of interest or high costs. So we're feeling increasingly positive about the momentum and traction that we're getting in the workplace with Income+. And as we wrap more key pieces into this, I think it becomes harder and harder for a product solution to replicate this holistic service solution that we put into the marketplace.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Does the employee have to opt into Income+ when they get Financial Engines, or is it just part of the package?

Jeffrey Nacey Maggioncalda

Increasingly, it is part of the package. We believe, as fiduciaries managing portfolios, that as you approach retirement, your objective typically changes from one of trying to accumulate assets and grow your portfolio to one of trying to protect your assets and ensure that you can get steady lifetime payouts. And because that seems to be the predominant preference, we are, as a matter of methodology, shifting people into this income objective using the Income+ methodology so that, I think, over time, you'll expect that more and more portfolios become income-objective portfolios. And that's something that's not absolute, 100% of the time. But increasingly, that is the primary way that we're managing these portfolios for folks close to and in retirement.

Raymond Jay Sims

The point, I think, is that the portfolio will be income ready. You don't have to take income starting at 65 or any other arbitrary age until and unless you want to. The ability to integrate the income over time with a IRA and, potentially, a rollover for a pension means that we're blurring the artificial distinctions from where -- in terms of where the money lives and making it a more holistic view of you have a pile of assets that has to last you your life, and whether they live in a 401(k) or a pension with a lump sum that will be rolled over or an IRA or a combination of them, we can calculate what the income is and still distribute it to you when you want it with flexibility to increase, decrease, stop or take a lump sum at any point in time.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Great. Last question on -- your cancellation rate was lower this quarter than I've seen in some time. I know do you do better on that, the voluntary cancel, in better markets, and you talked about your focus on the cancellation rate and some of the strategies. I mean, are you seeing anything that you're doing having an effect on the cancellation rate at this point in time, or do you just think it's all -- that the improvement is all because the markets are better, and how you measure that?

Jeffrey Nacey Maggioncalda

Yes, we don't know for sure exact attribution on the cancellation rates. We do categorize cancellations based on reason and also based on tenure. So internally, we separate cancellations that happen in the first 90 days with cancellations that happen post that, and obviously other tenure cohorts as well. And so what you find is that typically, in 90 days, the market has a less dramatic impact on cancellation rates. And we are seeing that there are things that we can do that seem to be affecting the 90-day cancellation rate. And so we continue to invest in this, and we are seeing positive results. So I would not say that all of that reduction in cancellation that you're seeing is attributable to the markets. I think that we are starting to understand and implement techniques that actually do help people feel better in the early parts of their relationship with us.


Next we have Hugh Miller with Sidoti & Company.

Hugh M. Miller - Sidoti & Company, LLC

So I guess, in following on the last question about the cancellation rates and some of the things that you're doing, I think one of the things you guys have commented on is just kind of trying to improve the personalization of the product. Can you just give us a bit more kind of color on what types of things you're finding and what aspects of that personalization you can do to try and improve and get someone to enjoy the user experience a bit more?

Jeffrey Nacey Maggioncalda

Yes, sure. So if you look at the product, there are many elements that an individual can personalize. And some of those personalizations happen automatically. If you look at the 700,000-plus portfolios that we're managing, about 3 out of 4 are unique to that individual. Nobody else has the exact same portfolio because we don't use model portfolios. The portfolios that we create are really constructed at the individual level. The factors of personalization that can influence that, and therefore, the parameters of personalization that people can change, include things like your retirement age, your risk preference, your company stock holdings preference, if you don't want to diversify as much of your company stock as we suggest that you do, and adding in outside accounts. We also personalize the portfolio based on your initial position, so that we try to minimize the portfolio turnover as we move you to what we believe would be an efficient portfolio on the efficient frontier. What we have been doing is increasing personalization through many different mechanisms. One mechanism are sort of the individual-initiated modes of personalization. This includes increasing your -- or decreasing your retirement age, changing your risk preferences, adding in outside accounts. And we have made efforts along all those dimensions to make people aware that you can personalize this. And across almost every dimension, we are increasing personalization rates. More people are changing their retirement age, more people are putting in outside accounts, more people are changing the company stock preferences. We found that engaging individuals with advisors is an important way to do that. Communicating the fact that you can personalize is an important way to do that. And we've been really simplifying what we call the first use flow, that first set of screens, to make it really easy to do personalizations. We also, last year, included an ability to personalize the portfolio based on the presence of the pension plan. So if you have an outside pension benefit, that actually does change the way that we manage your portfolio. It's not something you would need to even tell us about. We typically -- or often have a connection with the pension provider, and the fact that, that pension is available to you will change the way we manage your portfolio. So these are all ways that we can increase the personalization rates. And it seems that customer satisfaction and, certainly, personalization increases when that happen. And of course, this is something target date funds can't do, and so it's something that we think adds value and differentiates our service.

Hugh M. Miller - Sidoti & Company, LLC

Okay, great color there. Are some of the challenges just a function of a lot of people wanting to use the system and having you guys do kind of the legwork and taking kind of a hands-off approach for themselves and then you having to get their participation towards the beginning in order to improve the service for them? I mean, is that kind of some of the give-and-take?

Jeffrey Nacey Maggioncalda

Yes. I think that if you look at it, when people engage with our advisors, you see very high personalization rates. And that means that someone was interested in talking to someone and they had an advisor explain that you can personalize these things and actually coaching in different ways to personalize them. So you can see, you're well in excess of 50% personalization for these advisors -- we call them retirement checkups for these, the retirement calls. Certainly, the biggest challenges for people who sign up because they just don't want anything to do with managing their 401(k), and maybe they don't know that any personalization is available, yes, you got to get their attention first, then make it really easy and then also provide them with a compelling reason why they should do it. And I think on all those dimensions of awareness, convenience and value perceived, we're making good progress.

Hugh M. Miller - Sidoti & Company, LLC

Okay, and then I think in the past, you guys have mentioned with the IRA product that there is the potential for this to have stronger margins than in your current core product. I was just wondering if you could just delve into that a bit more if that's in fact the case, and what kind of drives that profitability? Is it just a function of kind of scale, or is it more function of the differential and fees that you could potentially charge? I assume not, but I just wanted to get some insight into that.

Jeffrey Nacey Maggioncalda

Yes, this is great. Thank you for using the word potential, because we are learning as we go along. And I think the specific reference we made is that we expected the gross margin to be higher. What we see in the IRA market is even charging well below industry fees, the fees are probably a little higher than the fees charged at the 401(k) plans because of market and the lack of scale and getting an entire employer at once. So the fees are a bit higher. Typically, the balances are higher -- or in many cases, the balances are higher. And the cost that we have to pay providers as opposed to providing a data connectivity fee to our 401(k) providers for building these customized, multi-level connections, certainly in the case of the earliest custodians, Schwab and TD Ameritrade, they already have RIA custodial platforms, and the fees that they charge to utilize those platforms are substantially lower than the fees we pay to our typical 401(k) providers. So essentially, there's a higher level of fees, at least initially. There's a lower level of amount of money that we have to pay to the custodian, which is the equivalent of the provider, so the gross margins are higher. Depending on customer acquisition and other costs, the profitability could be higher or lower, but we'd probably start off with higher gross margins.

Hugh M. Miller - Sidoti & Company, LLC

Got you, okay. That very helpful. I mean, any way that you can help us quantify to what degree the margins would be, relative to your current?

Jeffrey Nacey Maggioncalda

I think we're going to wait a little while until we get up a head of steam. We typically report on issues, like the size of the market and how much of our assets it's going to be, after a full year in the marketplace, which would put us early in 2014. At this point in time, the numbers are small enough that they're not distorting the totals.

Hugh M. Miller - Sidoti & Company, LLC

Yes, that I understand. Okay, that's helpful. And then the last question I had was just with regards to a handful of the line items, there seem to just been some higher costs in the quarter than what I was anticipating. I was wondering -- obviously, you guys have had some strong marketing efforts. But was there anything kind of unusual in this particular quarter that was lumpy or seasonal that we should be considering for the back half of the year?

Raymond Jay Sims

No. I would say, in Q2, we have a higher level of campaigns. And with campaigns come higher provider costs and this accounting oddity of reimbursed print costs, where we recognize the reimbursement as revenue because we have to, but the entire print cost and expense, there was a bit more of that. Q3 is typically the highest quarter for campaigns that we have. But I don't think there should be much distortion in the expense lines that's seasonal or cyclical. I think what you tend to see is gross margins at the lower end of that 60% to 65% range that we've talked about in the past, and our operating expenses typically growing more slowly than revenue, which would lead to operating income margins increasing over time.


The next question we have comes from Mike Grondahl of Piper Jaffray.

Michael J. Grondahl - Piper Jaffray Companies, Research Division

The first one is, I think you said in some of the prepared remarks that 16 of your plan sponsors have over $1 billion in AUM now. Could you maybe...

Jeffrey Nacey Maggioncalda

Yes, that's right, Mike. This is Jeff. Yes.

Michael J. Grondahl - Piper Jaffray Companies, Research Division

Could you point me to 1 or 2 things that are unique about those 16 that allow them to be so successful?

Jeffrey Nacey Maggioncalda

Yes, this is -- at the risk of sounding really silly, they're really big plans. I mean, some of our plans have more than $20 billion in the 401(k) plan. And so you get a modest enrollment rate, and you're talking $1 billion. Some of them do have -- opt out in very high enrollment rates as well. But generally it's -- again, it sounds very simplistic. They're pretty big plans with pretty good enrollment rates.

Michael J. Grondahl - Piper Jaffray Companies, Research Division

Got you, okay. And then is there anything we should think about as markets have been higher now for 8 to 9 months, not so much in regards to enrollment, but just sort of your discussions with plan sponsors. I mean, do they have a better appetite to sign you up as markets trend higher or less of an appetite? How should we think about that?

Jeffrey Nacey Maggioncalda

Yes, I think that what we've seen historically, and this is going back over a number of years where we've seen extreme cases of negative markets and we've seen, recently, pretty positive markets, we have definitely seen that negative markets, to the tune of kind of late 2008, can be very distracting. Plan sponsors get absorbed with doing damage control on their fund lineup, making sure that none of their investment managers have kind of gone off the rails with respect to investment style, and they get very absorbed in their fiduciary monitoring processes. But certainly, down markets are not great immediately. They do sort of reinforce the need for our types of services. To your question on the up markets, it's been interesting. In this up market, it doesn't seem like -- I've not heard sponsors say, "Hey, you know what, I think my participants are going to be okay since their balances are going up." I think that they continue to be very concerned about the decrease in health benefits that people are going to be receiving. They understand that the pension plans are not growing. They've been frozen. In some case, they are thinking about even winding those down. And so they see a curtailment of that important retirement benefit. And they look at that savings rate and the balances in their plan and they say, "It's a lot of money that's been going up because the markets have been pretty good, but on a per person basis, when you think about much retirement income is going to come from these things, it's nowhere near enough." So I don't think that the up markets have really either increased or decreased, much, the sponsor appetite for our services.

Raymond Jay Sims

Things often happen at speeds that could be characterized as glacial in this world. And one of the things, which may be moving glacially is, as markets have done very well, the funded status of defined benefit pension plans, when you combine it with the higher discount rate that companies are now allowed to use, has made the percentage of funding in some plans higher, although the dollar value of underfunding continues to go up. And with companies having historic levels of cash on their balance sheet, the thought process of, "If I were going to de-risk a defined benefit pension plan, this might be a reasonable time to think about it. And where would those assets go? And if I either encourage or force my employees to take lump sums or annuities, is there somebody who could manage the retirement picture?" leads to some interesting, albeit preliminary, discussions with sponsors. So longer term, up markets could be our friends, but it tends not to react terribly quickly.

Michael J. Grondahl - Piper Jaffray Companies, Research Division

Okay. And then just lastly, I think you said that Income+ is now available at $52 billion of your $74 billion of AUM. Do you expect 100% coverage? And is there kind of a sight line to it?

Jeffrey Nacey Maggioncalda

Yes, so a slight difference from what you said. The Income+ is available to $54 billion of our $667 billion of AUC, not AUM. So it represents a fairly small -- less than 10% of our AUC currently. When you look forward, though, to something else that we announced today, that we have a new provider who's just gone live with Income+, so we are continuing to line up these commitments and live connections, we are now covering in excess of 70% of our AUC with live connections and over 95% with committed plus live connections. Now to get the whole book of business, in terms of the Income+, actually getting it rolled out at the sponsor level, of course, the key things you need to do is first, get the provider commitment, then you need to need to get the provider connection, then you need to get the sponsor to agree, and then it counts as Income+ AUC. We're currently at less than 10%. I think it will be -- I don't think we'll be able to get to 100% because there's always some sponsors, for various reasons, who have certain concerns about something. But I expect that this is going to look like an S curve. And it's hard to estimate when the inflection point happens, which is why we've been a little slow in getting these connections live. But in my opinion, we have now reached a certain level of critical mass, as evidenced by the commitments and live connections, that is saying, "You know what, sponsors are getting much more comfortable and consultants are getting much more familiar with our service." And because we designed it in such a way as to really try to reduce the amount of barriers or objections or concerns that sponsors have, that S curve, I expect, is going to look pretty steep. So I don't think we're going to get to 100%, but I think that the steep part of the S curve, we're just about to hit it, and I think that's going to go pretty high before it starts leveling off. Not to 100%, but I think it's going to go pretty high.

Raymond Jay Sims

So with 95% of the assets covered, we pretty much have all of the providers -- or nearly all the providers either live or with commitments to customers to go live. 95% really covers pretty much all the big guys. For sponsors that like the methodology but either haven't or won't change their 401(k) plans to allow periodic distributions, the ability to roll assets into an IRA and provide retirement income from the IRA covers all of those people. So we do not expect to see substantial objections from sponsors in the market.


The next question we have comes from Avishai Kantor of Cowen and Company.

Avishai Kantor - Cowen and Company, LLC, Research Division

[indiscernible] lower-cost [indiscernible].

Raymond Jay Sims

We're not hearing the audio.

Jeffrey Nacey Maggioncalda

Avishai, a little bit louder. We're having trouble hearing.

Avishai Kantor - Cowen and Company, LLC, Research Division

Can you please talk a little bit about your lower-cost noncampaign marketing efforts? That's my first question.

Jeffrey Nacey Maggioncalda

The lower-cost, noncampaign marketing efforts, yes. So probably what you're referring to is the digital -- sort of ongoing digital marketing that we sometimes refer to as the sort of integrated enrollment that's built into the provider's website. Is that what you're talking about?

Avishai Kantor - Cowen and Company, LLC, Research Division

Yes, correct.

Jeffrey Nacey Maggioncalda

Great. So the key pieces of that are getting placement on the provider's site, so that our messages can show up when someone logs in and looks at their balances. There are 2 flavors that we have of that. One is a static version, where we tell the provider, "Hey, here's the person that is on your site," and we just give data, and they render the actual message and image. There is a second version, which is the more recent one, where the provider simply says to us, "Here's who's on the site, you guys render the message." And we're basically been rolling out this version 2.0 where we can actually do the personalization and customizations much more rapidly. We're now -- we continue to make progress in actually getting the placement and doing it with this version 2.0, we call it the frame server, where we're actually it up within the frame on the provider side. That's been going quite well. Then you want to find a message that people find relevant to them based on their situation in life, their age, maybe what's happening in their portfolio, so that they clink on it. And once they click, do they get interested in either using our online advisory service or enrolling in Professional Management? We call them the click rate and the convert rate, which is how many -- what percentage of people see the message, click on it, and what percent of the people who click on it then decide to enroll. And we have been making good progress in understanding more about the types of messages that people click on and what types of messaging and sort of experience entices folks to sign up. And that press release that I mentioned that Vanguard had put out puts some numbers on it with respect to Vanguard's experience, so I'd suggest that you go take a look at the Vanguard press release. It will give you some general idea of what these clicks and convert rates are, at least for Vanguard. The nice part about this -- you alluded to the lower-cost method. The nice thing about this is this is all digital, so the marginal costs are essentially 0. We do have to pay money, and it takes time to get the thing integrated, but once it's there, it's persistent, it's ongoing and it can be personalized and there's no postage or printing involved, so it really reduces the marginal cost of serving up this type of marketing.

Raymond Jay Sims

After licking 10 million stamps, my tongue gets tired.

Avishai Kantor - Cowen and Company, LLC, Research Division

Great. And my next question is, following the discussion on competition, do you guys meet any start-up companies that are entering the investment advisory space in the traditional IRA market?

Jeffrey Nacey Maggioncalda

We don't see -- let's see, we don't see any real competition from direct independent advisors showing up in the large plan workspace market. I understand that a number of firms, smaller firms in particular, have seen the attractiveness of the market in terms of the size of the assets, and they have announced that they're entering the space. This is over the last year or 2. We don't see much traction. And I wouldn't say anybody, in terms of a new entrant, has registered in any meaningful way with respect to competition. So I know that there's interest and people who are acknowledging that this is a big opportunity. I have not seen any party, in terms of a new entrant, get traction in the space. But I'd say the biggest competition remains the possible substitution effect with target date funds. I mean, that really is our primary competitive initiative is to broaden and differentiate the services from target date funds, which continue to get cheaper and cheaper, frankly, as these products get commoditized. So that's really the competition that we focus on.

Raymond Jay Sims

And as people age and their lives become more complex and personalization becomes more important -- obviously, target date funds treat everybody the same. And as people start looking at the prospect of both developing an income-ready portfolio and then actually looking to receive regular income from the portfolio, target date funds don't really have the capability to say, if you're in a 2015 fund and it's 2015, now what? So we think that's been a real differentiator. And smaller entrants who recognize the size of the market, in our view, may struggle with customer acquisition costs, which is why it's really nice to start from the workplace, where we can get our potential customers tens of thousands at a time by focusing on the large plan market.


It appears that we have no further questions at this time. We'll go ahead and conclude our question-and-answer session. I would now like to turn the conference back over to management for any closing remarks. Gentlemen?

Jeffrey Nacey Maggioncalda

I think that's it. If there are no further questions, we appreciate people's time, and we'll be happy to follow up with folks individually if requested.

Raymond Jay Sims

Thank you for your interest, and August. Good bye.


And take care, sir, we thank you for your time also. The conference call is now concluded. At this time, you may all disconnect your lines. Thank you, and have a great day, everyone.

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